Removal of a malignant tissue involves a painful surgery; and the recent demonetisation of R500 and R1,000 notes is no exception. The denotification of currency of these denominations is indeed a big gamble. If it succeeds it would be a reform, much more significant than the abolition of the licence permit raj in 1991; or any other reform undertaken by any government since independence. If it fails, the economy might plunge in to a recession which might be difficult to shake-off.
The measure will have short-term as well as long-and medium-term impact. In the short run-which is all that matters for most people, the lengthening queues outside ATMs and banks is only the beginning of the problem. Hopefully, people will be able to deposit, withdraw and exchange their old notes for new ones before the situation gets out of hand.
A much more serious problem, however, is the one that confronts the informal as well as certain sections of the formal economy that run largely on cash–namely retail, agriculture, gems and jewellery, real estate, SMEs, etc. For these segments, demonetisation is a money supply shock because they have suddenly lost their medium of exchange.
As any professor taking an Economics 101 course will vouch, wiping out 86% of the money supply in a sudden strike, however precise, is bound to make money scarce, raise private interest rates, and contract demand for both private consumption and investment. Two important components of aggregate demand will, thus, immediately register a contraction. This will in turn lead to lower prices, lower GDP, increase in unemployment and a recession. The vital question facing the nation today is whether improvement in money supply subsequently will lift these sectors out of recession. There are some economists who feel that instead the recession might spill over into other sectors because all of them are dynamically interlinked to one another. In fact, that is what happened in the US, when sub-prime mortgage crisis broke out in 2008.
Regardless, one immediate consequence of demonetisation will be the transfer of resources from private hands to the government. Since not all the demonetised notes of R14.83 lakh are likely to find their way back to banks, some extinction of RBI’s liability will take place. When demonetisation last took place in 1978, about 20% of the liability of the RBI got extinguished. The economy at that time was much smaller, and the demonetisation of high value currency affected very few people. This time the game is very different; the income-tax department has more sophisticated technology and analytical techniques to trace out transactions carried out by tax evaders. As a consequence, many people may prefer to take a direct monetary hit rather than surrender their high denomination cash hoardings to banks and expose themselves to prosecution. As they may fear that they may not be able to explain how they acquired so much cash in the first instance. If this happens to 50% of the cash hoardings, the government will be richer by R7.41 lakh crore, which is currently about a year’s collection from income-tax. The government may spend this on building infrastructure, reducing its debt to the public, or improving the position of its fiscal deficit.
Simultaneously, the banks will be flush with funds. They will be in a better position to absorb the NPAs generated in the past and reduce lending rates for their customers. Whether managers will acquire the courage to actually take risks and lend is, however, a totally different issue.
The effect on income-tax revenues will in all likelihood be mixed bag. Since with the new technologies available, it will be easier for the department to track transactions of citizens. Existing taxpayers, too, could be expected to report higher incomes in future. However if a recession does set in, these positive effects may be offset by taxpayers genuinely earning lower incomes as result of which they may pay lower tax. Much would, therefore, depend on how the positive and negative effects of demonetisation balance out in future.
In the medium and long run, however, if the government’s gamble pays off, the nation will reap rich dividends. Sources of terrorist funding and all kinds of other socially harmful activity will dry up. India will emerge as a modern economy in which cash plays an insignificant role. Prices will come under control. Banks will be in a much better condition to lend. Government finances will be much healthier than what they are now. Equity and bond markets might flourish, and the country’s sovereign ratings too will improve.
Much more, however, needs to be done to ensure that this outcome is achieved. The I-T department will have an important role to play. Its new strategy could perhaps aim at making the cost of evasion as high as possible; and simultaneously, the cost of compliance as low as possible. It may want to depend much more on techniques available in modern information technology–such as data warehousing and analytics–rather than on individual discretion, for selection and investigation of scrutiny cases. In order to strengthen the tax base and attract and retain new taxpayers, it may find it fruitful to enquire into taxpayer needs and see how best these could be satisfied. One way surely would be to simplify and demystify complex provisions so that ordinary taxpayers can comply with them without incurring extra-ordinarily high compliance costs.
Hopefully all this, along with reduction in tax rates, will bring some sunshine in our winter of discontent!
The author was chief commissioner of income-tax and ombudsman to the I-T department, Mumbai